Working Paper: CEPR ID: DP4231
Authors: Frederic Palomino; Abdolkarim Sadrieh
Abstract: Following extensive empirical evidence about ?market anomalies? and overconfidence, the analysis of financial markets with agents overconfident about the precision of their private information has received a lot of attention. All these models consider agents trading for their own account. In this article, we analyse a standard delegated portfolio management problem between a financial institution and a money manager who may be of two types: rational or overconfident. We consider several situations. In each case, we derive the optimal contract and results on the performance of financial institution hiring overconfident managers relative to institutions hiring rational agents, and results on the price impact of overconfidence.
Keywords: optimal contract; overconfidence; risk-taking incentives
JEL Codes: D82; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| overconfidence is observable (G41) | optimal contracts can be structured (D86) |
| optimal contracts can be structured (D86) | rational and overconfident agents choose the same investment strategy (G11) |
| overconfidence is observable (G41) | no price impact (G19) |
| overconfidence is not observable (D80) | overconfident agents may perform better than rational agents (D80) |
| overconfidence leads to higher effort levels (D29) | lower risk and variance of returns (G11) |
| overconfidence can lead to a positive expected return (G41) | less risk than rational agents (D81) |
| overconfidence affects prices (G41) | market maker must account for uncertainty (D84) |
| contract structure influences investment behavior (G31) | market outcomes (P42) |